JPMorgan Loss Turns New Scrutiny on Federal Reserve

After John Pierpont Morgan stepped in to quell the panic of 1907, U.S. lawmakers created the Federal Reserve in 1913 as a lender of last resort to defend against future financial crises.

Almost a century later, the disclosure of a $2 billion trading loss by the man who now heads the Morgan banking empire, Jamie Dimon, has prompted calls to end an arrangement that Vermont Senator Bernie Sanders calls “a clear example of the fox guarding the hen house.”

The bill signed by President Woodrow Wilson created a decentralized institution with a Washington-based Federal Reserve Board and 12 regional banks. Each has its own president and board that includes representatives from the banking industry. Dimon, chief executive officer of JPMorgan Chase & Co., has served since 2007 as a director of the Federal Reserve Bank of New York, the entity that oversees Wall Street banks including Dimon’s, the largest U.S. lender.

“The optics in a situation like this are not good,” said Alfred Broaddus, former president of the Richmond Fed. “Maybe it is fair now to take a look at this structure and see whether it still makes sense.”

Sanders on May 22 introduced the Federal Reserve Independence Act, along with Democratic Senators Barbara Boxer of California and Mark Begich of Alaska. The bill to ban employees of bank holding companies or other firms regulated by the Fed from serving on regional boards calls the arrangement a “conflict of interest that must be eliminated.” Sean Oblack, a spokesman for the Senate Banking Committee, said the bill is being reviewed. A hearing hasn’t been scheduled.

Support Seen

Sanders, an independent, said in a June 14 interview that while Democratic leaders have not assured him they will allow a vote, he will try to force one as an amendment to unrelated legislation. He said a coalition of “progressives and some of the very conservative members who have long-term concerns about the Fed” would join in support of the bill.

“It advances the discussion because of the timing, as clearly Dimon is what raised the issue,” said Mark Calabria, director of financial regulation studies at the Cato Institute in Washington and a former Senate Banking Committee aide.

Fed Chairman Ben S. Bernanke told Congress on June 7 that the central bank would be willing to work with lawmakers on the bill. “If Congress wants to change it, of course we will” work with them, Bernanke said. “Congress set this up,” and “we’ve made it into something useful and valuable.”

Fed Meeting

Bernanke and fellow Fed policy makers meet in Washington today and tomorrow to consider whether to increase record monetary stimulus to spur a weakening economy.

Dimon, in testimony today at a House Financial Services Committee hearing about JPMorgan’s $2 billion trading loss, said regional Fed banks benefit from industry leaders’ input. The board is “more of an informational, advisory group,” he said. “Whatever the lawmakers write would be fine with me.”

Still, he said, “If I had a board, I’d want to hear from a lot of different types of people. It’d be funny to be talking about global markets and not have someone involved in the global markets at the table. It certainly does not have to be me.”

Board members have no role in the supervision or regulation of banks, and reserve banks may not share confidential supervisory information with directors.

Elizabeth Warren, a Democrat running for U.S. Senate in Massachusetts, called for Dimon’s removal from the district bank board. Treasury Secretary Timothy F. Geithner has said having bankers on the board of the New York Fed creates a “perception” problem.

Balance of Power

The Fed’s structure has its origins in efforts to find a balance of power between politicians in Washington, representing farmers and small businesses, and Wall Street financiers.

“The creation of the Federal Reserve was controversial, almost a battle between banking interests in New York on the one hand with opposition and a lot of concern from the populist segment in Washington,” Broaddus said. “Whoever says ‘What’s that guy doing on the board?’ doesn’t know all the background.”

The compromise created a central bank that was both independent of the government and decentralized. Having regional reserve banks “meant that monetary policy would not be completely dominated by the New York financial community or the Washington political process,” said former St. Louis Fed President William Poole.

Emergency Lending

The Fed was also given the power to lend to banks in emergencies, as the Morgan-led consortium of bankers did to avert a deeper economic crisis in 1907. Morgan propped up the stock market by pressuring bankers to form a pool of money to bail out stockbrokers. The first Federal Reserve Board, led by Chairman Charles S. Hamlin, was sworn in on Aug. 10, 1914.

The Federal Reserve Act created nine-member boards for each of the reserve banks and assigned three of those seats to bankers. Banks in each district select six directors, including the three bankers, who give advice on regional economic conditions. The Board of Governors in Washington picks the other three members. The six directors who aren’t bankers represent the public.

“There’s an image problem, but that image problem has been there for 100 years,” said Allan Meltzer, a professor of political economy at Carnegie Mellon University in Pittsburgh who has written a history of the Fed. Congress reduced the role bankers play on reserve bank boards in the 1930s, 1970s and again with the Dodd-Frank Act of 2010, Meltzer said.

Dimon was on the New York Fed’s board in 2008 when the central bank agreed to take $30 billion of Bear Stearns Cos.’s mortgage assets to facilitate JPMorgan’s purchase of the failing investment bank.

Political Backlash

The political backlash that followed Fed bailouts of American International Group Inc. and Bear Stearns prompted lawmakers to curb the influence of bankers on the regional Fed boards when they drafted the Dodd-Frank Act, the biggest overhaul of financial regulation since the Great Depression.

Under Dodd-Frank, bankers on the regional Fed boards may no longer participate in the choice of presidents, a move that the New York Fed’s William C. Dudley in a September interview said he supported. Lawmakers rejected a proposal to make the New York Fed chief a White House appointee subject to confirmation by the Senate.

Dodd-Frank also required a Government Accountability Office audit of the central bank, which was completed last year and found the Fed needs to strengthen policies governing conflicts of interest and improve transparency.

GAO Conclusions

The GAO said it found no evidence of reserve bank directors making decisions about approving borrower participation in emergency programs. Bernanke, in a reply included with the report, said the recommendations “all have merit” and the Fed “will work to implement each of them.”

“We have to take appearance of conflict really seriously because it does affect the institution by creating questions about our credibility,” Dudley said in the September interview.

Representative Barney Frank, a Massachusetts Democrat and co-author of Dodd-Frank, wasn’t satisfied. He introduced a bill in November to remove regional Fed bank presidents from the Federal Open Market Committee, which votes on monetary policy.

Regional presidents “are neither elected nor appointed by officials who are themselves elected,” Frank wrote in a position paper. “They are part of a self-perpetuating group of private citizens who select each other and who are treated as equals in setting federal monetary policy with officials appointed by the President and confirmed by the Senate.”

Frank’s bill has no co-sponsors, and the Republican-led House hasn’t scheduled any action on the measure.

Presidents Rotate

The FOMC is comprised of the seven governors plus five regional Fed presidents. The president of the New York Fed is vice chairman of the FOMC and has a permanent vote, while the rest of the regional presidents rotate onto the committee.

The 7-3 vote at the FOMC meeting last August underlined the need to replace the presidents, Frank said in the paper. The Dallas Fed’s Richard Fisher, Narayana Kocherlakota of Minneapolis and Philadelphia’s Charles Plosser dissented against the Fed’s statement that economic conditions were likely to warrant “exceptionally low” interest rates through mid-2013, a time frame that has since been extended to late 2014.

The regional Fed bank presidents have been among the most vocal critics of the Fed’s easing policies, which have included purchasing $2.3 trillion of government and agency mortgage-backed securities.

Defending Role

The regional presidents defend the role of bankers on their boards. Kansas City’s Esther George last month said in a statement that they provide “critical, in-depth information about economic conditions in their communities.”

“It’s been a good system,” St. Louis Fed President James Bullard told reporters June 5. “People think it’s crazy but it’s not.”

Gary Stern, who led the Minneapolis Fed for 24 years until retiring in 2009, said bankers don’t need to be on boards to offer advice.

“If I were starting from scratch with a clean slate, I think in today’s world I probably wouldn’t want bankers on the board for the perception reasons,” he said in a May 30 interview. “A reserve bank president can call up any banker who he wants to and ask them what’s going on.”